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Should You Be Tempted To Sell Five Below, Inc. (NASDAQ:FIVE) Because Of Its P/E Ratio?

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Five Below, Inc.'s (NASDAQ:FIVE) P/E ratio to inform your assessment of the investment opportunity. Five Below has a P/E ratio of 46.77, based on the last twelve months. That is equivalent to an earnings yield of about 2.1%.

See our latest analysis for Five Below

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Five Below:

P/E of 46.77 = $128.91 ÷ $2.76 (Based on the year to November 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

Does Five Below Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (16.5) for companies in the specialty retail industry is lower than Five Below's P/E.

NasdaqGS:FIVE Price Estimation Relative to Market, December 31st 2019

Five Below's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

How Growth Rates Impact P/E Ratios

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.

Five Below increased earnings per share by an impressive 20% over the last twelve months. And it has bolstered its earnings per share by 31% per year over the last five years. This could arguably justify a relatively high P/E ratio.

Remember: P/E Ratios Don't Consider The Balance Sheet

Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

Is Debt Impacting Five Below's P/E?

Five Below has net cash of US$132m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Bottom Line On Five Below's P/E Ratio

Five Below trades on a P/E ratio of 46.8, which is above its market average of 18.9. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. Therefore it seems reasonable that the market would have relatively high expectations of the company

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.